Gloom and doom

Market analysis
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12/22/2018

Each week still looks like the last. Although there was nothing new to report as far as fundamentals were concerned, investor perception deteriorated further. The Fed’s 25bp rate hike was expected but came with comments that some saw as uncertain and others as worrying pointers to growth momentum.

US-China tensions had been abating but resurfaced on espionage rumours. The threat of a Federal shutdown only made things worse.

Markets are now expecting earnings to fall in 2019 although neither economists nor financial analysts share this view. It is therefore more than likely that the market sell-off has been overdone.

We are maintaining a slightly overweight stance on equities. We also think that unless the global economy collapses in 2019, the slide in oil prices now means there is an interesting entry point for energy stocks.

European equities

With the threat of a US shutdown hovering in the background, European equities plunged after the Fed proceeded with its fourth rate hike of the year. This was expected but the outlook for monetary policy in 2019 was more restrictive than investors had bargained for. And yet, the agreement between the EU Commission and Italy over the 2019 budget was cause for some optimism as it removed a lingering eurozone uncertainty.

The oil sector continued to fall with the oil price. Cyclicals and tech were even worse hit by this surge in risk aversion. The aerospace sector fell after the US launched a judicial enquiry into Airbus which is suspected of irregularities in sales made before 2010. And Deutsche Bank fell on news of an EU investigation into possible price fixing in US Treasury trading in the US.

There were also several profit warnings. Online clothing distributor ASOS plunged after cutting its annual sales and margin guidance following particularly poor November trading. Ceconomy, Europe’s largest consumer electronics distributor, issued its third profit warning this year while Natixis said its fourth-quarter revenues would be hit by losses in equity derivative trading on Asian markets. The group will nevertheless pay a generous bonus dividend thanks to the sale of its specialist funding division to BPCE.

In an active week for corporate transformation news, ABB gave into pressure from the activist Cevian fund and sold its power grids division to Japan’s Hitachi for between $7.6-7.8bn. ABB will also launch a share buyback programme and a new cost-cutting drive. Cevian also took a stake in Nordea, the largest northern European bank, and is now demanding urgent measures to increase shareholder value. LVMH paid $2.6bn in cash to acquire up-market hotel specialist Belmond. In the pharma sector, the UK’s GSK and Pfizer in the US are to merge their mass market healthcare activities. The resulting joint venture will mostly be held by GSK and will have $13bn in sales. Eiffage increased its exposure to railways by paying €307.5m for more than 5% in Getlink which runs the Channel tunnel.

US equities

In a very difficult week, the S&P plunged 5% and the Nasdaq 6%. This month could be the worse December since 1931 when the Dow Jones lost 17% The Russell 2000 index is now 24% off its August highs and technically in a bear market. Volatility has exploded with the VIX hitting 28, its highest level since February. Safe haven stocks bucked the trend. Overall sentiment has moved into very pessimistic gear and, in only a few weeks, hedge funds and small investors have dramatically reduced risk exposure.

Market weakness was primarily driven by the Fed’s statements and the threat of a shutdown at midnight on Friday December 21. The S&P 500 tumbled 3.7% after the Fed’s press conference, the worst market reaction to a rate hike since 1994. Investors had been hoping for a much more accommodating tone. Jerome Powell suggested more caution in the future but ignored Donald Trump's warnings and went ahead with the year’s fourth interest rate increase. The Fed now sees two more hikes in 2019, down from three after last September's meeting. It has also trimmed its growth forecasts for 2019 from 2.5% to 2.3%. This year, the US economy has grown by 3%, the best performance since the financial crisis.

Japanese equities

After sharp declines on Wall St, Japanese equities lost ground across the board on mounting worries over a global downturn and the stronger yen. The TOPIX tumbled 4.71% over the week. Ahead of the Christmas holidays, heavy selling by non-Japanese investors, including hedge funds adjusting positions, amplified the move. Small cap stocks remained weak as a few trillion Yen of Japanese small investor money was absorbed by SoftBank’s huge IPO. The new issue started off trading below the IPO price.

Not only economically sensitive sectors such as Mining, Marine Transportation and Securities & Commodities Futures were hit but also defensives like Pharmaceuticals, Services and Retail. AEON dived 13.62%, Daiichi-Sankyo plunged 11.11% and Astellas Pharma lost 10.93%. One exception was SUZUKI Motor, strong in India and not dependent on the US market, which managed to jump 5.48%.

The BOJ remained on hold at its Monetary Policy Committee meeting and stuck to its monetary easing programme, including ETF purchases. For 2019, Shinzo Abe’s administration is offering a JPY 5.7 trillion stimulus package to offset the economic downturn which is expected to be triggered by the consumption tax hike, scheduled for October 2019.

Emerging markets

Although Xi Jinping’s speech to mark the 40th anniversary ceremony of China’s Reform and Opening-up did not detail any new initiatives for reforms, the Central Economic Work Conference in the following days unveiled some encouraging proactive fiscal policies such as more significant tax and fee cuts starting next year. The PBoC also launched the new targeted MLF (median-term lending facility) and another RMB 100bn in relending to small banks to support loans to the private sector. Several lower-tier cities marginally loosened property purchase restrictions.

Tencent outperformed this week as the GAPP (General Administration of Press and Publication) completed its review of the first batch of new games and said it was speeding up the release of the publication numbers for those games. Tencent is also reportedly joining Naspers in a $1bn funding for India’s online food delivery company, Swiggy.

Following the Fed move, Thailand raised its policy rate by 25bp to 1.75% despite core and headline inflation below its 1-4% target.

India’s central bank announced a further step up in open market operations to infuse liquidity and recapitalise public sector banks. At the newly indicated pace, this would amount to around 2% of GDP in FY19 or about 65% of the government’s planned FY19 borrowings. The increase in OMOs has led to a sharp drop in yields, which are down 90bp from September highs.

In Russia, US sanctions are expected to be lifted if Congress does not block the deal within 30 days. In Brazil, central bank policy makers believe the risks for inflationary pressures are low but continue to see risks skewed to the upside with forecasts at 3.9% in 2019, 3.6% in 2020 and 3.7% in 2021. Embraer was said to be taking steps to challenge San Paulo injunctions halting the Embraer-Boeing deal. If the deal goes through, Embraer may pay up to $1.7bn in a dividend.

In Mexico, Banxico raised rates by 25bp to 8.25% as expected and remained very hawkish. Earlier this week, President Amlo presented the 2019 budget, which is in line with consensus expectations of a 1% fiscal surplus, but with an aggressive assumption of GDP and oil production growth. Colombia’s congress approved a tax surcharge on banks, adding 4% in 2019 and 3% in 2020 and 2021. This will offset the positive effect of tax-burden relief in the short-term and weigh on the expected earnings recovery next year.

Commodities

Gold prices added another 1.7% while equity markets fell sharply. Since its August 16 low of $1,174 due to extremely high shorting, the ounce has bounced by more than 7%. During the same time, the MSCI World equity index has fallen by 12%. Gold equities have at the same time risen by 14% in US dollars thanks to their beta. This performance deviation has been much more marked since October 9 due to bond market tensions and mounting worries over a trade war.

Trading in recent days was influenced by the latest FOMC. The Fed has cut expected hikes in 2019 from three to two but markets were hoping for just one move. However, current equity market weakness and a possible fall in the US dollar could translate into no hike at all next year. This is good for gold and markets seem to have rediscovered its safe haven properties. Comex trading positions have now turned positive and are at highs not seen since mid-July. ETF flows are also now positive year to date.

Meanwhile, oil prices kept on falling. Brent crude plunged 10% over the week and WTI 13%, taking both to lows not seen since September 2017. This looks excessive, especially as inventories are today much lower, but the market is now dominated by news flow rather than fundamentals. And the news is still negative: worries over global growth and the possible impact on oil demand - revisions to oil demand expectations have so far been only marginal - as well as doubts over the ability of OPEC and Russia to regulate the market by significantly cutting output. Future US inventory trends will be very closely watched in coming weeks.

Corporate debt

Credit

The Xover widened by 17bp and the Main by 6bp between Monday and Thursday. However, Italian corporates were boosted after Italy reached an agreement on its 2019 budget with the EU Commission.

S&P rated auto manufacturer Peugeot BBB- or investment grade, citing robust performance and a successful recovery. Fitch had previously awarded the same rating in November. Moody's downgraded Spain’s Aldesa (construction) by one notch to B3, citing an earlier-than-expected increase in leverage and the worsening economic climate in Spain and Mexico.

Dia’s bonds came under attack. The last two directors representing its main shareholder, LetterOne, resigned as board tensions increased. All this occurred as the group tried to negotiate a new €200m short term loan from a syndicate of 14 banks. S&P reacted by cutting the group from B to CCC+ and Moody’s moved from B2 to Caa1 with a negative outlook.

Vallourec (steel tubular solutions) had already alarmed investors when its third quarter results revealed heavy cash consumption and it came under further pressure, this time from hedge funds who are looking at the €2.2bn loan facility that the group has not used.

In results news, Takko unveiled a 5.9% drop in sales and a 5.2% fall in EBITDA. However, trading in November and December looked more promising.

SoftBank (Ba1/BB+) listed its telecoms subsidiary. The €20.3bn IPO was the second largest in the world.

Convertibles

This week saw a run of poor date. First, China announced the lowest retail sales growth since 2000 and industrial production at a 3-year low. Then the preliminary estimate of the eurozone’s manufacturing PMI for December was the lowest since 2014. In their much-anticipated statements, both Xi Jinping and Jerome Powell disappointed markets. China’s president said nothing much new and seemed less focused on growth than expected. The Fed's chairman announced a 25bp hike but struck a less accommodating tone than expected and said there would probably be two more rate increases to come in 2019. And, just like the ECB in the previous week, the Fed revised its growth and inflation forecasts for 2019 lower.

Equity markets lost more ground but, remarkably, this time the US underperformed other markets. Credit spreads widened but Italy's spreads actually narrowed. Thanks to their sector bias, European convertibles proved rather resilient in the downturn, more so than US convertibles.

Low end-of year trading volumes meant the new issues market was rather idle. Only Benefitfocus Inc., a healthcare small cap with $1.5bn in sales, launched a $200m convertible. The issue price was not known at the time of writing but the coupon will be between 0.75/1.25% and the issue premium between 30/35%.

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